Week 38: Markets Dive on Investor’s Fears

September, 23, 2011 – This was the worst week of trading for the year as investors fled from equities out of fear the economy is heading into a second recession and that the European debt crisis will worsen. The decline in the markets was the worst since the week ending October 10, 2008, when the DOW lost 1,504 points, or 15% of its their value. The week’s trading was also disappointing to those who felt that after almost three years of languishing, the economy would finally be on the road to recovery. While we questioned the lack of conviction in Week 37, there was no mistaking how investors felt about the future this week —and it was not pretty. On Wednesday and Thursday, the markets declined 674.83 points as sellers exceeded buyers.

For several months, the markets have been in a tug-of-war over whether the European debt issues would affect international markets and pending that news, the markets would react accordingly with volatile days of ups and downs. However, with the recent increase in the value of the dollar, it appears that despite all of Uncle Sam’s troubles, investors preferred to hold dollars over other currencies this week. Yet in an odd turn, the Chinese Yuan, long viewed as undervalued, declined against the dollar this week.

The reaction in the markets started on Wednesday and continued into Thursday as the Federal Reserve began to implement Operation Twist in an effort to revive a stalled economy. The essence of the program is a version of the Federal Reserve’s previous two stimulus programs called “Quantitative Easing,” but without expanding the balance sheet of the Fed. The current plan calls for the Fed to sell $400 billion of shorter duration assets and replace them with an equal amount of longer maturity treasuries over the next nine months. In so doing, long-term interest rates are expected to decline and thus make long- term borrowing more attractive. However, with the lack of success of the Fed’s past two programs (Quantitative Easing I & II) in getting the economy back on its’ feet, some are wondering if this latest effort will yield similar results.

The selloff in investments was broad. Not only did equities fall, but gold (often thought of as a safe alternative in some investor’s minds) saw a decline, as did oil. Other investments that fell were corporate bonds and copper. Such broad selling was taken as a sign that investors were simply unloading any investments they felt would be risky, or were trying to cover their losses. To add to this, hedge funds have been taking short positions (selling stocks they do not own) on the belief that the markets are heading down. (When one sells short, they sell a stock they do not own and purchase it at a later date in the hopes of buying it a lower price and thus making a profit.) Shorting the market can push it down and likewise, those who do short the market can cause a sudden rebound (called a “short squeeze”) if they suddenly feel their short positions were poorly placed. This means that those who short the market need to purchase shares to cover themselves; this often occurs when there is an unexpected piece of good news to counter the shorts’ negative position.

Adding to investor’s fears was new data indicating that Chinese manufacturing is declining. China has long been viewed as the growth engine for the world’s economy, so a slowdown in manufacturing certainly could have ripple effects in those nations that rely on Chinese trade.

Finally, it appears that the U.S. Congress is in another budget dispute. As mentioned in The QR, investors have not been supportive of Washington’s recent game of chicken. This is certainly not helping investors feel optimistic about the future. As the Presidential race heats up, it is apparent that the markets are not favoring the most recent actions (or inactions depending on how you look at it) of Congress. Echoing a previous post of The QR, Peggy Noonan noted in Saturday’s Wall Street Journal (WSJ) that unless the Republicans alter their tactics, they could end up losing the 2012 race. In her words, “As I said, Mr. Obama can’t win this election, but the Republicans can lose it by being small, by being extreme, by being—are we going to have to start using this word again?—unnuanced.” It will be interesting to see if the GOP will get this and accept that while their base is cheering the rhetoric, Wall Street isn’t. Considering the WSJ is the voice of conservative, pro-business, free-market philosophy and pulls no punches with President Obama, one can only wonder if the party will take this advice or continue on its current path.

Taken together, the news from Week 38 left very little for investors to cheer about resulting in the week being one where the conviction was markedly sour. However, make no mistake, the markets have been volatile and as we have noted numerous times, a bad Week 38 can easily be erased. With such a steep weekly decline, it would not take much to get this week’s selling reversed. The news would not need to be terribly exciting, but more on the line of, Uncle Sam still has a heart beat! Which by the way, he does.

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